Human face of regulation

Speech by Martin Wheatley, Chief Executive, the FCA, at the London School of Economics, London

martin wheatley speech migration.jpg

The reach of behavioural economics

The creation of the FCA – the new financial conduct regulator – is a direct response to what hasn’t worked. Time and again over the last 20 years we have had major scandals – pensions, endowments, insurance, savings – every one is a blow to confidence in finance and every time there is a big clean-up bill for the industry.

The traditional response to a mis-selling scandal (and not just in the UK) was to require more disclosure of information. The assumption was that if you give rational people more information, they would be better able to take rational decisions.

We got this wrong. We all can, and indeed do, make rational decisions when we can get our head around all the different moving parts. Financial decisions usually however, have too many moving parts – multi-year scenarios, unknown interest rates, deferred consumption and the joys of compound interest – that’s too many for the average person. And that’s where behavioural economics fits in.  

And it is an area that will, I think, be a hugely important feature of the new regulatory system so I hope you’ll all walk away agreeing that it was an entirely rational, logical decision to attend this lecture this evening…

I’d like to use this evening’s session to explain how the FCA will be using behavioural economics in the years ahead. But first I wanted to take a step back and put our work into some context.

Freedom of choice is one of the characteristics of a market economy that we most often take for granted.

We would like to think we have the ability to select and pay for products according to cool and calculated judgement; that we can analyse risk proficiently and assess reward proactively.

But experience tells a different story, that the vast majority of us aren’t always level-headed risk assessors or careful selectors of products. We don’t always choose the right mobile phone tariff or the most appropriate credit card.

Instead, we live in a world of complex psychological pushes and pulls that can quickly define and direct our choice of purchases and use of products.  

Indeed, thanks to decades of work by behavioural economists and academics like Simon, Tversky, Thaler and Kahneman, we are able to point to a huge variety of subtle psychological triggers that are capable of explaining everything from why we tip waiters more when they bring a chocolate with the bill. To why we spend on credit today even though it might prevent us from buying something more important tomorrow.

In other words, the vast majority of us are not as calculating as we might like to believe in our financial decision making.

We like to think we can be deliberative and reasoned, certainly for the big decisions. That we weigh up data, take a long-term view... consider different options. But we don’t always need to operate in that mode: it’s ok to be intuitive and spontaneous as well – even if you’re a regulator – but hopefully we are intuitive and spontaneous for things we understand well – or maybe for the small decisions we make every day that may not matter much.

But the problem with financial decisions is that they generally do matter a great deal – and we do not always understand them well. Faced with all the moving parts of a financial decision we find it hard to employ the rational mode so we revert. We react to them instinctively and automatically. Faced with the inability to apply our rational model – we revert to what is easier: the intuitive.

  • If a box is ticked at the bottom of a contract, we’re likely to leave it ticked.
  • If the person dresses smartly and works for a well known brand name – we trust them.
  • If we see a framed professional qualification on an office wall we’re more likely to believe the person we’re talking to.
  • If we’re given the right nudges, we’re more prone to miss the particular weaknesses of various products.

One of best examples of which is the now infamous experiment by researchers who sent out marketing letters for personal loans with a variety of pictures on the front, each advertising a different interest rate.

Those that went out with a picture of an attractive woman on the front were shown to command a significantly higher interest rate – 24 per cent a year higher – perhaps because the human mind, in both male and female respondents, links the attractive person to an attractive product.

In my previous role in Hong Kong all the marketing fliers for structured products were on red paper (lucky) usually with a pot of gold.

So, we do not carefully evaluate data or analyse statistics in reaching important economic decisions. Nor do we weigh up the evidence in exquisite detail.

Instead, we use mental short cuts. Short cuts that ‘aren’t’, as Jonah Lehrer pointed out in the New Yorker last year: ‘a faster way of doing the math’ but ‘a way of skipping the math altogether.’

Historical approach to regulation

One of the most significant challenges for modern financial regulators and financial services alike is to recognise that we operate within this very human environment. A fallible world governed and directed by psychology:

  • temptations that lead people to overstretch their finances;
  • mental shortcuts that don’t always work and can lead us astray;
  • anchors that lead us towards particular outcomes;
  • and frames that change our perception of a given choice. None of us is immune from these influences.

Yet one of the features of regulation historically was that it was all about compliance. It was almost robotic. Were a particular set of rules followed and boxes ticked? Could a firm demonstrate and document that it had followed those rules to the letter? Did firms disclose the full, un-redacted detail of their products to customers?

If companies were able to tick those boxes and confidently hold up their product’s terms and conditions in court, they were assumed safe from regulatory scrutiny.

But in many cases this reliance on rules, processes and disclosure simply encouraged firms to hand over more information to customers who were already confused. More text, more figures, more legalese.

And at this point, after disposing of their regulatory duty to the letter of the law, if not the spirit, they would invariably ask for a disclaimer that the customer had read and understood the small print. That, yes, the decision was their own.

My most extreme example of this was not in London but in Hong Kong. When I challenged a bank on mis-selling a product, they handed me over the documentation in defence. In this case that an 83-year-old woman had signed a 200-page English legal document, asserting she had read and understood the terms, and could withstand any losses.

My problem was not one of gender, or age – it was that the signature on this 200 page English legal document was an X – she only read Chinese.

So, over the years we have often seen product design, marketing and sales processes accentuate and distort the effects of human biases: teaser rates to take advantage of customer inertia; bizarre insurance exclusions tucked away in the small print; terms and conditions for financial products longer than Hamlet.


Regulators have a choice as to how they handle this type of challenge.

There is an argument that risk should squarely sit with the consumer. This is the ‘buyer beware’ – caveat emptor – approach that says poor decision making by customers is not the responsibility of businesses. 

Certainly the fact that mistakes are made, and then made again by consumers, doesn’t automatically mean they shouldn’t take personal responsibility for decisions.

But ‘buyer beware’ does become harder to defend when customers are buying seriously complicated financial products.

We are not talking about products that will either work or fail within 14 days – these are products that may not pay off a mortgage 25 years later, or provide a pension 40 years later. By which point, you can be sure that any records will have long been lost; the adviser long retired.

A perfect example has been some of the more exotic structured products offered by firms. Products that have often been mind-bogglingly complicated financial gambles – almost like spread bets on steroids.

One example I saw involved consumers tying up capital for between one and six years with their returns dependent on the share prices of three technology firms.

If, after one year, the share prices of all three are at, or higher than their initial price, the investor receives 12 per cent return and the product stops.

If, after two years, the share prices are at, or higher than 90 per cent of their initial price, the investor receives 24 per cent and the product stops.

If, after three years, the share prices are at, or higher than 80 per cent of their initial price, the product pays 36 per cent and so on and so on.

But if after six years the final price of any of the three shares is below 50 per cent of the initial price there will be a capital loss based on the performance of the worst performing company. So you could quickly lose a substantial chunk of your money.

Is this product a good deal? Frankly, I’m not convinced. But you can see the attraction. These are large returns and the companies involved are doing very well at the moment. A rational decision maker would work out a statistical estimate of return based an understanding of probabilities of different outcomes. The intuitive approach says 36% sounds good and this is a brand name firm.

These situations are repeated again and again in financial services because of the inherent complexity of the products. They are questions that many investors simply may not ask because we are humans, not automatons. Susceptible to behavioural biases, to framing, to anchoring, to poor decision making.

Regulators need to have the power and expertise – the remit – to anticipate these influences and react to them.

But the last regulatory system, for all its strengths, was sometimes a little too Spock-like (for the Star Trek fans) in its deliberations and decision making.

I want the FCA to use its new powers and remit to bring a more human face to the regulation of financial services. A more pragmatic, sophisticated approach to regulation. To be a little more like Captain Kirk, perhaps a little less like Mister Spock.

Not only so we can defend against sharp practice, and sometimes not even “sharp” practice in the Arthur Daley sense – just business in the maximising of returns sense; but also to encourage better decision making among consumers.

And that’s why the FCA is taking its first steps towards incorporating behavioural economics into the regulatory fold.

RCTs and disclosure

On top of this event, our economists are building an understanding of behavioural economics into how we assess markets; how we think about competition; how we develop and test potential solutions.

We have also begun looking at specific issues where we think behavioural economics has something important to tell us, including consumer redress.

It’s interesting to look at how people respond to ‘redress’ letters. A ‘redress’ letter is where something has gone wrong with the product or sales process – a firm writes to the customer saying they are owed money back. That should be easy – you should tick the box that says ‘yes please’ and wait for the cheque. In fact that’s not what people do. Most people – sometimes 80% ignore it.

We know that these kind of response rates vary widely – and often for predictable reasons. Maybe the amount of money at stake – you would be less inclined to apply for £10 of redress than £1,000. Maybe because of the level of public awareness. Has the redress campaign appeared in the papers, on TV, in advertising?

Yet in some areas we know consumers are not always paying sufficient attention to letters for more subtle reasons. Perhaps because we are busy, forgetful or haven’t been given enough information. Perhaps because we are suspicious of letters from firms that might conceal marketing or bad news.

All of these factors can, and do, hinder us from claiming when we should be coming forward.

One of the trials we’ve just completed involved working with a firm that was voluntarily, and proactively, writing to almost 200,000 customers about a mistake in the way it had sold a product. We agreed with the firm to test different versions of the firm’s letter as part of a randomised controlled trial.

The firm’s original letter, written in good faith but designed without the use of any behavioural economic ‘nudges’, had a very low response rate.

When we randomly varied the letter with simple amendments, including:

  • reducing the amount of text;
  • explaining to readers that the claims’ process would only take five minutes;
  • putting the main thrust of the message in bullets at the top of the letter;
  • or by sending out reminders…

… the rate of response jumped by over ten per cent. The equivalent of an additional 20,000 people responding. Or over half a million pounds in extra compensation.

These were important results, unexpected results in many ways, but what I think was particularly revealing was that the original letter sent out by the firm was not obviously poor. It did not need major cosmetic surgery.

What I found interesting was that these very subtle behavioural economic insights we used could have such a profound impact on response rates – and in very different ways than you might expect.

So, bizarrely including the Chief Executive’s signature instead of the customer service team actually reduced response rates, particularly amongst women.

So, we will be using more trials like these to improve customer outcomes, particularly in areas like the disclosure of information by financial firms – where the potential is there to yield big returns. Not just for consumers, not just for those who might be vulnerable to making poor decisions.

But also for firms, for the providers of these services who want their customers to make the right decisions.

How the FCA will use behavioural economics in the future

And this is a crucial point I think. It would be entirely wrong to pretend all firms use behavioural economics for their own Machiavellian ends. Or that all marketing teams are hell bent on misleading customers. Far from it.

The best financial service companies, the most consumer-focused, go to considerable pains to make sure their customers are steered towards the best products and the most suitable.

We should applaud these firms and learn from them:

  • Greg Davies at Barclays Wealth, who is now doing pioneering work to both help investors understand their preferences and behavioural tendencies, as well as to use this knowledge to achieve better investment performance;
  • The Allianz Centre for Behavioural Finance, which is working with Shlomo Bernatzi to create practical systems for financial advisers, and plan sponsors, to help clients and employees make sound financial decisions;
  • And Aviva, which is using behavioural economics to help encourage more people to save for their retirements by enrolling into workplace pensions.

I am entirely supportive of these firms, and many others like them, that use behavioural economic insights openly, and honestly, to provide a better customer service – to steer consumer behaviour positively.

Psychology can be a hugely effective and important tool in helping us understand what people want. It is unequivocally not just about finding mistakes.

But the new FCA won’t be afraid to shine a light on the murkier psychological enticements and entrapments that exist in financial services. The dark arts of behavioural economics. The pushes and pulls, the frames and biases that we sometimes see used to entice customers to buy financial products they may not need, or that might be wholly unsuitable for them.

In other words, we will be looking across markets to see where and how behavioural economics might support our regulatory activity. Looking at areas like auto-enrolment, auto-renewal, information disclosure and product complexity.  

So, for example, could we use behavioural economics to understand why some consumers do not switch from one savings product to another after a teaser rate expires?

Patrick and his team have already shown, very effectively I think, just how crucial these decisions not to move can be.

Teaser rates are very common in financial services – in savings products, mortgages. If you look at the best buy tables for either, you find that these rates are good for a defined period – one year; two years – and then revert. So, you may see a savings product offering 3 per cent today, but then reverts to 0.1 per cent after the first year. The smart consumer switches at the end of that year to a new teaser rate. What do most people do? – nothing! They stay in these products like a frog boiled in water

Figures from Which? tell us two in five customers are currently earning interest of just 0.5 per cent or less.

And one in five are getting just 0.1 per cent or less a year, equivalent to £1 in interest for saving £1,000 for a year.

Why do so many customers take no action when the letter, email or T&Cs tell them their fantastic sounding rate is ending and they’re being shifted to a far lower, far less attractive rate of interest?

Why do so many pass up the opportunity to earn hundreds, possibly thousands of pounds extra simply by switching their investments to alternative financial products?

In too many cases, the honeyed promise of teaser rates fails to match the long-term expectations of customers for financial return. At their worst, they can be the financial equivalent of the Venus-fly trap, enticing consumers towards a product and relying on human inertia to keep them there.

This kind of product feature poses some tough challenges for regulators.

Is the psychology behind them too flawed, too morally opaque, for them to be offered to the man-on-the-street? Or could we simply use behavioural economics to refine and improve the way they work – and to support better customer outcomes?

The second, related area, where I think we need to ask serious questions is whether there is scope for behavioural economics to specifically support the FCA’s new competition objective.

One of the Government’s major concerns, one of my major concerns, is that there’s currently too little competition across some of our most important markets. We may think we have a competitive banking industry, but you are more likely to change your spouse than switch bank accounts. Its customer choice that keeps firms competitive.

In other words, not all firms face any great incentive to sing for their supper – to work for their market share.

Looking forward, the FCA wants to empower customers; to switch to the new best rates or move between suppliers.

We want the regulatory system to use behavioural economics to ascertain whether people are being put off switching products through inertia, inattention or even the simple fear of regret from making a wrong decision.

How can we, in the words of Daniel Kahneman, get around the ‘bias that favours the status quo’?

We know, for example, that motor companies sell far more add-on insurance policies when customers are automatically opted-in to their insurance, than they do when customers specifically have to ask to be registered.

In fact, during our work on motor legal expenses insurance, one insurance group explained to us that the biggest factor affecting purchase was the default.

If customers were opted-in then 80 per cent bought the add-on insurance. If customers were opted-out and had to actively purchase then just 40 per cent bought it.

The same story is often repeated in auto-renewals, where the financial ombudsman receives hundreds of complaints every year on contracts that roll over again and again, without any input from the consumer.

So, we know this kind of choice architecture can be a very powerful mechanism for firms.

And could we also use behavioural economics to weed out products that are too complex for their target market – and may even be specifically designed to benefit from consumer mistakes?

Many structured products fall in this category – products with too many moving parts; products that are almost impossible to take a rational decision on. So you revert to the instinctive – what is the headline promise; do I like the look of the salesman; is there a pot of gold on the poster?


So, we know there is huge scope for using behavioural economics to understand consumer decisions, to support firms and to improve regulation.

But we should not pretend this is a straightforward discipline. There is no mechanical routine to follow when we apply behavioural economics to regulation. It will require us to change the way we identify risks, diagnose problems and troubleshoot.

It’s also worth pointing out that behavioural economics is not enough, on its own, to guarantee good regulation or strong financial products. It is a part only of the new FCA’s identity. But it is an important part and I want firms to be ready for these changes and to believe that they are going to happen.

The FCA is and will be much more consumer-focused. But consumer-focused does not mean consumer-biased. We still need to reach good judgements – weighing up the actions and interests of both firms and consumers.

We need to rebuild confidence. We need consumers to have access to the right products. And to do all of this, we need to press the reset button for the industry. The creation of the FCA and our new approach is the start of that process.